Ideas for Intelligent Investing

Category Archives: Market Valuation

As of the close on September 30, 2009, the yield on the S&P 500 was 5.68%, based on trailing 5-year earnings. This compares to a yield of 4.82% for 10-year AA corporate bonds and 3.31% for the 10-year U.S. treasury. See the sidebar section entitled “Market Valuation” for links to the data. Although stocks don’t look cheap, the yield advantage of the S&P 500 over that of 10-year treasuries compares to that of other bear market lows. Caution: the yield on the S&P 500 changes markedly depending on what period is selected to calculate the earnings portion of the yield. The key here is to think about what normalized earnings would look like for the index.

With the S&P 500 at 1065.49, its yield currently stands at 5.63%, based on an average of its five-year trailing earnings. Although the spread has narrowed, it still enjoys a 2.24% yield advantage over the 3.39% yield of the 10-year U.S. Treasury. This compares favorably to past bear market lows.

Although the price to earnings ratio of the S&P 500 is not cheap by historical standards, the S&P 500 still enjoys a yield advantage over government bonds owing to low interest rates. For now, this may give stocks room to move higher, although, at some point, interest rates will probably go higher, if the recovery is solid. Notwithstanding the fundamentals, sentiment could continue to drive the market well beyond what the fundamentals can justify, if those left on the sidelines during the first half’s massive rally choose to chase stocks.

Focus on the valuation of your holdings, not price levels. Think carefully about risk and how your portfolio is positioned.

Another tool I use to gauge the valuation of the stock market is to compare the earnings yield of the S&P 500 (based on trailing earnings for the past five years) to the earnings yield on the 10-year AA corporate bond.

The spread has narrowed considerably with the S&P 500 yield currently at 5.85% and the 10-year AA corporate yield at 5.07%. Here is the data.

Based on this, the market does not appear to be undervalued. Investors should become increasingly cautious (fearful) as the market rises.

With the market rising approximately 50% from the March 9, 2009 low, I thought it was appropriate to look at what Buffett considers the “best single measure of where valuations stand”: the market value of all publicly traded securities as a percentage of GNP.

According to Buffett, “If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%–as it did in 1999 and a part of 2000–you are playing with fire.”

According to my calculations the ratio currently stands at 89.4%. Generally speaking stocks look neither under or overvalued at this level.

As the general market averages continue to climb, I thought it would be constructive to write about some of Buffett’s thoughts on the general market. These are drawn from his partnership letters.

From the February 6, 1958 letter:

When Buffett ran his partnership he would calculate the intrinsic value of the general market. The intrinsic value calculation for the market as a whole related to blue-chip securities. He felt that all stocks would be affected by a substantial decline in market prices.

Buffett seems to adjust his exposure to undervalued equities based on his calculation of the general market’s intrinsic value.

Although Buffett pays attention to the level of the general market, his primary focus was on finding undervalued securities. He was not making a forecast of either the stock market or general business conditions.

Buffett believes that a market decline is a time of opportunity because there are more undervalued securities available.

Luck is an important factor in short-term performance of the stock market.

From the February 11, 1959 letter:

Market psychology is a major factor in determining the level of the stock market. This affects amateurs and professionals and can continue to drive up market prices as long as these participants believe there is easy money to be made in stocks.

Buffett believes that there may be relationship between the duration of a run-up in stocks and the eventual reaction to it.

The general public, in Buffett’s view, believes that stock market profits are inevitable.

Stock market prices and intrinsic values can move independently.

Buffett looks at a stock market decline as potentially advantageous, if it allows him to add to his position in an undervalued security.

Buffett expects to find fewer undervalued securities when the market level is high.

Buffett does not believe he can predict the future movements of the stock market or general business conditions. He expects that over time there will be down years (some relatively severe), up years and those in between. It is not possible to predict their magnitude or sequence. However, over the long term the level of return will reflect the performance of the underlying businesses. In 1962 he expected this to be 5% to 7% based on a combination of dividends and reinvested earnings.

One of the limitations of Price to Earnings (P/E) Ratios is the volatility of earnings from year to year, particularly in a recession. The combination of reverse leverage, where earnings fall faster than revenues, and write-offs can cause P/E ratios to actually expand in down markets. There are several approaches to normalizing earnings to make the P/E ratio more meaningful. One that I like to use is the Price to Peak Earnings Ratio. This was made popular by investment manager John Hussman. Other approaches to normalizing earnings include looking at Price to 10-Year Average Earnings, which is used by Yale Economist Robert Schiller.

Currently, the Price/(Peak Earnings) ratio is 11.65. To me, it looks like the general market is neither markedly under or overvalued based on this indicator. As always, these indicators should be taken with a “grain of salt” – they all have their limitations. One factor that currently favors stocks is the level of interest rates, which were higher at previous bear market lows. Ultimately, stocks must compete for the yield available from competing assets. Currently CD’s, High Yield Money Market Accounts, and Treasuries offer very little yield.

Here is a link to my data. I will also add a link to the data on the blog’s main page.

In my blog yesterday entitled “How Cheap are U.S. Stocks?”, I compared the the 5-year average earnings yield of the S&P 500 with the yield of the 10 year U.S. Treasury. I then compared the ratio of these two yields to that of past bear market lows. Based on this metric, U.S. stocks look to be still priced attractively.

Today, I want to compare the the 5-year average earnings yield of the S&P 500 with the yield of 10 year AA corporate bonds. This is a meaningful comparison because investors have a choice between equities and bonds. If they can obtain a yield in high-quality corporate bonds that equals that of equities, it may put downward pressure on stocks.

As of July 23, 2009, the yield on 10 year AA corporate bonds was 4.9% compared with a 6.6% yield for the S&P 500, based on yesterday’s close. This gives the S&P an advantage of 1.7%. The advantage was 5.23% at the March 9, 2009 stock market low.

In an August 6, 1979 article in Forbes, Warren Buffett said we can think of the stock market as a kind of bond with a fluctuating coupon. That coupon is the earnings yield of the stock market which we calculate by dividing the earnings of the market by its price. If the earnings yield of the stock market is materially higher than that of the bond market, it may indicate that stocks are cheap.

In a December 19, 2008 letter to the shareholders of Longleaf Partners, Mason Hawkins, along with the fund’s management team, asked the question, “How Cheap are U.S. stocks?” To provide an answer, they compared the 5-year average earnings yield of the S&P 500 with the yield of the 10 year U.S. Treasury. They then compared this ratio to that of past bear market lows.

I have adopted their format as one the tools I use to value the overall stock market. This is not about timing the market, but, rather, assessing whether it is under or overvalued.

On Tuesday, July 21, 2009, the S&P closed at 954.58. This gave the S&P an earnings yield of 6.75%, based on its trailing 5-year average earnings of $64.43.

This is 1.91 times the 3.53% yield of the 10 year U.S. Treasury, which gives the S&P a yield advantage of 3.22%

Here is how the ratio of 1.91 compares with other bear market lows:

October 4, 1974 – 1.4 (S&P yield advantage: 2.7%)

August 12, 1982 – 1.0 (S&P yield advantage: 0.4%)

October 19, 1987 – 0.7 (S&P yield advantage: -2.3%)

July 23, 2002 – 1.1 (S&P yield advantage: 0.4%)

It is interesting to note that on March 9, 2009, which was the low point for the S&P in the first half of 2009, the S&P’s earnings yield shot up to 9.86%. This gave the S&P a yield advantage of 7.36% over that of the 10 year U.S. Treasury, and made the ratio swell to 3.94.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures.
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